When it comes to construction lending, nothing is more important than going in with your eyes wide open.

Construction lending comes with a lot of risks, so fully understanding those risks is an essential part of every lender’s job. In fact, there are significantly more risks in construction lending today than there were just two years ago.

Despite those added risks, the strategy for a successful construction loan remains much the same: knowing fully where your project stands, understanding your project’s risks and how the project can best be executed—and using the proper tools and best practices to mitigate potential risks. The execution of the project doesn’t really change, you are just “building a better mousetrap.”

Understanding Today’s Current Risks

Expecting the unexpected and properly preparing for ways to mitigate risks is just one part of a lender’s job. Keeping current with the market, the changing practices of contractors, and the risks they both present is the second part. Below are four big risk factors construction lenders should currently be aware of.

1. Material cost escalations. Material prices are up; this isn’t news. However, it’s important to note that these prices change constantly. This means that right now, no contractor is holding costs/quotes more than two to four weeks. So, when a lender is making a loan on a project, there is a necessity of speed to execution. A delay can cost the project more money because the bids will be out-of-date and need to be rebid. That being said, as you are deciding whether to loan on a project, always make sure the pricing is current.

2. Escalation clauses and allowances. These are the elephants in the room (aka contract) no one likes, but everyone should know about and learn to expect them in construction contracts now (or until the market has settled).

What’s an escalation clause? It’s a clause that allows the contractor to increase the owner’s price of the materials after the contract is signed if material prices increase unexpectedly beyond the contractor’s control. It allows the contractor to shift some of the risk to the owner, so everyone shares in the cost impact.

Until the last year, escalation clauses were not common; an increase in price was a risk owners preferred to place on the contractor. The last time we saw this happen was in 2007-2008 when projects experienced significant inflation prior to recession. Since then, these clauses have been newly dusted off and used more broadly than in the past.

Because of the unique and significant nature of today’s problems, contractors are no longer willing to take all the risk. However, with the risk also falling on owners/borrowers, lenders must understand how this can affect the loan and the borrower’s ability to meet loan requirements. Lenders must understand how risks will be mitigated and dealt with.

What contingencies are in place and how might they play out? It’s very important the project be penciled out to cover all known and perceived risks before closing the loan. Mitigate as many risks as possible, within reason of making it a marketable deal, since the project ultimately needs to be able to support itself. Remember, contingency is for unknowns, and budgets should be established for those known and perceived risks.

What about allowances? Allowances aren’t a new concept; they are set asides/budgets for elements of work that can’t be scoped or priced at the time of bidding (e.g., decisions on cabinets not made yet). Allowances traditionally ranged from 5-10% of the contract, but they have gotten significantly bigger and are ranging around 20-25%. In fact, we have seen these numbers be as high as 40% due to contractors who, unable to sign subcontractors until the loan was closed, were unwilling to take on the risk of escalation.

Allowances also allow the owner to take advantage of potential reductions in costs for items that aren’t needed on the project until later in the schedule, if the owner believes certain costs might come down. In any case, the lender should provide a specific window to the owner/contractor to award the subcontracts and reduce the allowances to a reasonable level. Although allowances in past markets gave the owner desired flexibility for undecided scope, now they protect the contractor from higher costs due to market volatility, which may put their business at risk.

3. Global supply chain crisis. Currently, there is incredible difficulty sourcing materials from domestic and international locations. Although supply chain has been an issue for more than a year now, it is a continuing concern because of unexpected circumstances that can occur (e.g., China locking down manufacturing). There is not much visibility into the issues that may arise. Last year it was difficult to predict where the problems were going to be, and now new problems arise every month. In addition, there are no known quantities of the supplies available like there were two years ago.

What does this mean to a construction project? It means the decisions that once could be postponed (like the previous cabinet pricing example) need to be made before a project commences. It also means projects require more money down early on in the schedule for material deposits/pre-purchasing. Hesitation in making early decisions and funding material deposits/purchases can lead to costly delays in the construction progress.

4. Labor availability. The labor crisis stems from many factors, including the following:

Fewer workers. COVID, unfortunately, has impacted the workforce and reduced it in ways it still has not recovered from. Some people left the construction workforce altogether, and many are aging out. In addition, there is a lot of difficulty recruiting young people, because there is diminished interest in joining the construction world.

Fewer bids. The lack of workforce also affects the number of contractors and subcontractors able to bid on a project. In fact, there are fewer serious bids on projects than ever before and/or more contractors turning projects down. Before lending on a project, lenders should ask the owner/borrower how many bids they received and how/why they made the specific selection. The selected contractor may very well be the only one willing and able to take it on. This may mean the pricing is not as competitive as in years past, and there may not be a replacement contractor in the wings in the event the original contractor defaults.

Building in a new area. Many projects are being constructed in new locations across the nation. The area may have a small workforce or supply pipeline that cannot support the volume of construction. A reduced workforce on a project will likely increase time to complete, which will also increase the cost to build the project.

Out-of-town contractors/subcontractors. When lending on a project, it’s important to know where the contractor and their subcontractors are based out of. Out-of-town contractors will possibly have a hard time finding local subcontractors, not know whether they are reputable, and may be unfamiliar with the market; all of these equate to added risk.

In addition, attracting subcontractors from out of town is tricky because travel time plus increased fuel prices create less interest in the project. An out-of-town contractor may not have the market pull with local subcontractors when it comes to staffing the project, because subcontractors may put their available resources on projects with local contractors with whom they may have longstanding relationships. The result can be a project with a small workforce and slow progress.

Subcontractors’ ability to honor obligations. Due to issues with the global supply chain already discussed, it may be difficult for subcontractors to honor their obligations. If they were hired to perform work during a certain time but a material delay or shortage postponed the project significantly, the subcontractors may not be able to honor their obligations once the project is ready for them—they may be committed to another project that was not delayed.

Vetting the Project Before Loan Closing

Thorough, timely due diligence on a construction project is crucial. In general, due diligence should be performed on the following: the borrower (which the lender conducts), the project’s documentation completeness, and the construction team. The latter two are typically outsourced to third-party consultants.

Documentation, budget, and construction schedule review. It’s important that a project have quality documentation and to know whether the scope of the project is well-defined. Where is the project in terms of drawings and permitting in order to quickly execute mobilization? How close is it to executing and locking in prices and delivery? Has a contractor been selected and where are they in the negotiation?

These reports do a deep dive not only into whether the plans are complete and realistic but also provide feedback as to whether the schedules and budgets offer an accurate representation of today’s market risks as well as areas of concern.

Contractor and construction team. The contractor is one of the most important individuals to the success of the construction project. Evaluating the contractor and knowing the contractor’s strength is, therefore, particularly important.

Does the contractor have the experience necessary to successfully complete the project? Is the contractor familiar with the product type (e.g., first time building a hotel)? Is the contractor keeping a positive cashflow or getting financially squeezed in too many places? Does the contractor have sufficient labor force (and have signed contracts)? How many projects is the contractor currently working on?

This type of review ultimately looks into whether the contractor and the team have the qualifications and capabilities for completing the project.

Putting Protections in Place Before Loan Closing

Putting extra risk management practices in place before loan closing offers the lender (and borrower) protections throughout the construction process. These practices will protect the project from delays, financial mismanagement, and defaults.

Construction monitoring. Having a project professionally monitored regularly ensures the project is progressing as required by the contract and to the standards/workmanship needed. In addition, it provides verification the work the contractor reports completed matches the actual work performed. In addition, the project’s monitor can flag project concerns or potential work hindrances early on.

Funds control. Although funds control typically goes hand-in-hand with construction monitoring, having a funds control process in place ensures funds are not being diverted to different line items or different projects and that payments are not being made ahead of scheduled milestones or deliverables. Most important, it ensures the contractor is paying all parties while providing diligent oversight and collection of lien waivers (aka, no liens on the project).

Default management. There are a variety of tools lenders can use to protect against defaults.

The most common are surety bonds, such as performance and payment (P&P) bonds, which offer monetary protection to the owner/borrower in the event of contractor failure. In addition, some consultants offer completion commitments that provide the services necessary to help get a project back on track in the event of contractor failure. Another tool now available is construction project completion insurance, which names the lender as beneficiary and provides immediate funding to complete a project in the event of borrower default.

Despite all the risks, construction projects offer lenders fruitful rewards.

Some lenders keep some of the risk mitigation practices, such as funds control, in-house to keep costs down. Electing to self-perform risk management should be a decision based on expertise and capacity. For larger projects, in particular, the benefits of having consultants with a larger sample size of experience, project pricing, and construction knowledge can be incredibly valuable.

It is also very important for construction lenders to be aware of both current and traditional risks and to perform proper due diligence and risk management practices on each project before closing on any loan.